Dividends
Legal and Director Duties
Legal Requirements
A Limited Company is owned by its shareholders. Dividends are a proportion of post-tax profits and may be paid to shareholders of a Company. When a Company intends to pay out a dividend it holds directors’ and shareholders’ meetings to declare such dividends. It is necessary for the meetings to be documented and to conform to the law.
Directors can pay dividends if it appears to them that they are justified by the profits of the company available for distribution. This can only be done by reference to the accounts of the company. (This requirement is met when you receive a breakdown of your company’s profit position as part of the service). A company may only make distributions out of its profits available for distribution. The technical definition is its accumulated, realised profits so far as not previously distributed or capitalised, less its accumulated, realised losses so far as not previously written off in a reduction or reorganisation of capital.
Many companies declare dividends once or twice a year. However there is nothing in principle preventing a company from declaring dividends as often as it likes provided there are available profits out of which to declare the dividends.
Dividends are not an allowable deduction in calculating corporation tax profits and therefore the corporation tax liability will be the same regardless of whether dividends are paid out or funds are retained in the Company.
It is important that correct procedures are followed with regard to the payment of dividends to protect against HM Revenue & Customs (HMRC) deeming a dividend paid as being “disguised salary.”
Director’s Duty
In addition to satisfying the statutory tests, when considering whether a dividend can be paid, the directors of a company must have regard to the company’s best interest generally (e.g. by having due regard to the future cash requirements of the business and to the present and future solvency of the company).
How Are Dividends Taxed?
Any net dividends you receive where your personal income (including salary, dividends and all other income you receive) is above (currently) £42,475 in the tax year, will effectively be taxed at 25%.
Hence, if you want to avoid any personal income tax on dividends, you should avoid paying dividends when your total personal income is greater than £42,475; or speak to us about other ways to limit your personal tax liability.
Any net dividends received by additional rate taxpayers where all your personal income exceeds £150,000, will effectively be taxed at 36.1%.
How Much Dividend Should I Pay Myself?
Extracting dividends and mitigating personal tax
If you decide to pay the maximum amount of dividend based on company profits, you can extract all realised profits after tax as a dividend, provided you have enough cash in the company bank account and have followed the appropriate steps.
You may, however, opt to leave some retained profits in the company to allow for the future business needs of the company or if circumstances change or to mitigate personal tax.
The fact that you can decide when to pay dividends to the shareholder(s) gives you flexibility in tax planning.
If you keep your personal total gross income, including dividends, below the ‘Upper Earnings Level’ (currently £42,475) for the tax year, you can avoid any personal liability to tax on dividends. The surplus of any profits can always be retained in the company and extracted in a future tax year when you expect your personal income to be leaner (thereby taking maximum advantage of your personal tax free allowances).
Bear in mind that the actual amount of dividend you can pay yourself will depend on all income that you earn (including from salary, dividends, interest, rental income etc.) throughout the tax year.
If you tell us about any previous income you earned in this tax year (e.g. from previous employment), along with any potential income you expect to earn outside of your company (e.g. rental income, interest etc. from other sources), we will be able to calculate an estimate and help you monitor your potential personal tax liability throughout the tax year to ensure that you do not exceed this ‘Upper Earnings Limit’. If you do exceed the limit, our estimate will provide you with an indication of the amount to set aside in your personal capacity to cover any potential personal tax assessed and payable (through Self-Assessment) on your personal income, including dividends.
Income Tax payable on Dividends
There are three different income tax rates on UK dividends. The rate an individual pays depends on whether their overall taxable income, after deducting their personal allowance ( currently 8,105), falls within or above the basic or higher rate income tax limits.
- 10% for dividend income up to or below the £34,370 basic rate tax limit ***
- 32.5% for higher rate income between the £34,370 and £150,000 higher rate tax limit. ****
- 42.5% for additional rate income over £150,000.
No NIC is payable on dividend income.
This result in the following three scenarios:
- Individuals with a total taxable income less than £42,475 (£34,370 + £8,105), the 10% tax due on a deemed ‘gross’ dividend is equal to the 10% notional tax credit, thus no further income tax is payable and they may receive dividends tax free.
- For individuals with a total taxable income exceeding £42,475 (£34,370 + £8,105), the tax due on a deemed ‘gross dividend’ is equal to 32.5% but they may deduct the 10% notional tax credit. This leaves an amount of tax actually due equal to 22.5% of the ‘deemed’ gross dividend which equates to 25% of the dividend actually received (22.5% x 10 / 9). Thus, any director with an existing income which already exceeds £42,475 will have to pay income tax at 25% on any dividend income paid.
- For individuals with a total taxable income over £150,000 a ‘super tax’ rate of 42.5% applies to their ‘gross dividend’ income. The notional tax credit (10%) is again deducted, leaving a net tax liability of 32.5%. This equates to 36.1% (32.5% x 10 / 9) of the actual amount of the dividend paid.
How much Dividend income may be received tax free?
Because dividends are paid to an individual out of the company’s remaining profits after Corporation Tax, it can be said that tax has effectively already been paid on dividends. For this reason a dividend carries a notional tax credit. Whenever a dividend is paid there is a notional tax credit equal to one ninth (1/9) of the amount actually received. For illustration purposes, when a dividend of £90 is paid, the notional tax credit is £10 (£90 x 1/9). The person is treated as if they have received a dividend of £100 (£90 + £10) but with a tax credit of £10 deducted at source. The deemed dividend of £100 (£90 x 10 /9) which includes the tax credit of £10 (£90 x 1/9) is referred to as the ‘gross dividend’. The £90 paid is referred to as the ‘net dividend’.
When it comes to totalling up the individual’s total taxable income the deemed ‘gross’ dividend is counted. The amount of dividend income which an individual can be paid tax free is therefore 9/10ths of the remaining unused amount of their basic rate tax band. Thus the maximum amount of tax free dividends which a director may receive in 2012/13 (if they had no other income) is actually only £38,227.50 (£42,475 x 9 /10) (and not £42,475 which is a common misconception).
One of the most tax efficient ways to operate as a shareholder of a limited company is therefore to draw a director’s salary of £7,488 (no Employer’s or Employee’s NIC due) and extract dividends of £31,488 (£42,475 – £7,488 = £34,987 x 9 / 10). This ensures you extract £38,976 (£7,488 as tax free salary and £31,488 as tax free dividends) which is the maximum tax free amount for the 2012/13 tax year.* (For Personal Service Companies, this is of course assuming all income is generated whilst operating outside of IR35)!
Notes:
*This is based on the assumption that the director has no other income besides salary from the company.
** Those with income over £100,000 lose their personal allowance by £1 for every £2 of income over this threshold. Those individuals earning in excess of £116,210 this tax year will lose their entire tax free personal allowance (i.e. £8,105) and will pay tax on all their earnings. This creates an effective marginal PAYE tax rate of 60% for salary between £100,000 and £116,210. For example, if you were to earn £114,000, you would have £14,000 above the £100,000 limit, which would be taxable at the 40% rate, so:
£14,000 x 40% = £5,600 tax. However, you would also have lost £7,000 of your tax free Personal Allowance, so this would also be taxable at the higher rate: £7,000 x 40% = £2,800 tax. The total additional tax as a result of earning £14,000 over the £100,000 limit is therefore: £2,800 + £5,600 = £8,400 which equates to 60% of the £14,000 earnings which is over the £100,000 limit. If, for example, you had a basic salary of £100,000 and receive a bonus of £14,000, you will find that 60% of your bonus is taken in tax.
*** The tax credit is restricted to 10% of the total gross dividends less the personal allowance. There is a 0% rate for the personal allowance because the notional tax credit is not repayable.
**** Remember, that income between £100,000 and £116,210 leads to the withdrawal of the personal allowance, thus resulting in an increased effective tax rate depending on types of other income.
If you are a higher rate taxpayer you will have to declare details of your dividends on your Self Assessment Tax Return. The additional tax due will depend on the level of your income and will have to be paid to HMRC by 31 January each year.
Income Made Smart: Limited Company Services
